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Mind Over Money: How Behavioral Finance Shapes Investment Decisions
Forbes Councils Member
COUNCIL POST| Membership (fee-based)
May 2, 2024,07:00am EDT
Investing can be exciting and rewarding, but it can also be fraught with psychological pitfalls and emotional detours. While charts and numbers play a pivotal role, it’s important to recognize that your financial journey is impacted by behavioral biases that lurk beneath the surface of your investment decisions.
Behavioral finance dispels the myth of market efficiency, revealing how our human flaws give rise to systematic errors in judgment.
Below, I’ll discuss some of the top behavioral biases that can potentially derail your investment goals and then share tips for not letting your emotions run the show.
Top Behavioral Biases Of Investors
1. Overconfidence: People often overestimate their ability and that of market strategists to make accurate near-term forecasts. This can lead to hasty short-term allocation decisions and excessive trading.
2. Recency Bias: Investors tend to give undue weight to recent information in their decision-making framework. This can result in overreacting to news flow and chasing the latest trend, rather than adhering to a sound investment strategy rooted in long-term principles.
3. Anchoring: Investors often cling to readily available information, such as analyst forecasts, and use them as anchors, making it challenging to objectively assess new data.
4. Confirmation Bias: People actively seek evidence that supports their preconceived opinions, which can lead to subjective decision making.
5. Loss Aversion: Human psychology is wired to feel losses more acutely than gains. This bias leads investors to cling to losing investments, hoping for a miraculous turnaround, while readily letting go of winners to avoid potential losses.
Examples Of Biases In Action
The market outlook for 2023 illustrates the impact of these biases. At the end of 2022, market strategists predicted that stocks would perform poorly the following year, suggesting that the negative momentum seen in 2022 would persist into 2023. This consensus view likely influenced at least some investors to trim their stock holdings, driven by their overconfidence bias in believing that these forecasts were directionally accurate.
Both the market prognosticators and individual investors were likely influenced by anchoring to the prevailing market sentiment and the recency effect following the financial market downturn of 2022. This negative sentiment and gloomy predictions led to loss aversion, prompting investors to park their money in safe assets such as money market funds while awaiting an all-clear signal.
Ironically, as the year progressed, the S&P 500 defied expectations by surging 26.3%. In hindsight, it became clear that these investment decisions, influenced by biases such as overconfidence, recency and anchoring, had proven to be suboptimal, underscoring how behavioral biases can lead investors astray.
Another example of recency bias is from the Federal Reserve and investors who assumed that the pickup in inflation above the Fed target of 2.0% in the middle of 2021 was transitory. Many market participants were anchored to inflation readings that were persistently below the Fed’s target for the past decade, which caused them to miss significant changes that occurred during the pandemic including to the labor market, supply chains and stimulus that had the effect of changing the inflation environment.
The failure to accurately assess incoming information led to policy being too easy for too long, and investors that were not positioned well for a sharp rise in interest rates in 2022 once it became apparent that the surge in inflation was not transitory.
Unfortunately, these types of examples are not uncommon. According to data from JPMorgan Asset Management and Dalbar, the average investor significantly lags broad market indices. From 2002 to 2021, the average investor returned just 3.6% per year, compared to the S&P 500’s 9.5% and a 60/40 portfolio’s 7.4%. The primary reason for this underperformance over time is the impact of behavioral biases on decision making.
Navigating Emotions While Investing
So, how can you harness the power of behavioral finance to become better investors? Here are some key take-aways:
• Acknowledge Your Biases: The first step in mitigating their impact is awareness. Identify your personal risk tolerance, and analyze past investment decisions.
• Embrace A Long-Term Mindset: Avoid chasing short-term gains or panicking during market downturns. Focus on your long-term financial goals, and stick to your plan, even when emotions threaten to steer you off course.
• Automate Your Investments: Setting up automatic contributions and rebalancing strategies helps counteract emotional impulses and keeps you on track.
• Educate Yourself: Learn more about behavioral biases and how financial markets work. The more knowledge you acquire, the better equipped you are to make informed decisions.
There are a number of good resources for people looking to learn more about behavioral finance. For the layperson, a good read is The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel. For a more sophisticated audience or people looking for a deep understanding, there’s Personal Benchmark: Integrating Behavioral Finance and Investment Management by Chuck Widger and Daniel Crosby.
Remember that while the market may have a target, your financial journey is unique. By uncovering your own behavioral biases and adopting deliberate investment habits, you can tame the turbulent world of investing from an emotional roller coaster into a path toward a secure and fulfilling financial future. Review your financial plan periodically and reach out to your financial advisor to assess your progress and gain valuable insights into optimizing your investment strategy.
Past performance is no guarantee of future performance. No investment strategy can guarantee a profit or protect against a loss. For more information and important disclosures, please visit: https://sa.nm.com/
Source: https://www.forbes.com/councils/forbesfinancecouncil/2024/05/02/mind-over-money-how-behavioral-finance-shapes-investment-decisions/
What Is the Difference Between Term vs. Permanent Life Insurance (And How to Choose)
by Jim Probasco
Updated: August 13, 2024
Edited by Erik Haagensen and Julia Kagan
Life insurance is one way to provide financial protection for your family and loved ones. Your monthly or yearly premiums bring peace of mind, because you know your family will be financially secure if you die.
The two main types of life insurance are term and permanent (cash value). Term insurance covers you for a specific period and delivers the coverage amount to your beneficiaries if you die before the term expires. Permanent insurance covers you for your lifetime and pays when you die, no matter when that happens. Both types of insurance require timely premium payments to maintain coverage.
Term vs. permanent life insurance: key differences
Term life insurance is simple and easy to understand. Some companies, such as Fabric Life Insurane by Gerber, sell only term policies based on both the simplicity and economy of this type of coverage. With term, you pay so much a month for so many years and are covered for a specific amount for that time period. It’s uncomplicated, effective, and economical.
Permanent life insurance, on the other hand, combines term insurance with an investment option, making it more expensive and more complicated. This is because part of your premium pays for term insurance and part is invested to provide potential future wealth or premium support.
Term Life Insurance | Permanent Life Insurance | |
---|---|---|
Duration | Typically five to 30 years | Lifetime |
Cost* | About $30/month | About $460/month |
Access to funds | No cash value to access | Cash value accumulates and can be borrowed or withdrawn |
Coverage | Up to $3 million | Up to $1 million |
*For a healthy 30-year-old male buying a 30-year, $500,000 policy – Source: aven Life by Mass Mutual.
What is term life insurance?
Term insurance is a life insurance policy that provides coverage for a specified time, typically five to 30 years. With this type of insurance you pay a monthly or annual premium. If you die before the term expires, the insurance company pays the death benefit to your beneficiaries.
Term insurance has no cash value. Your premiums only pay for insurance during the life of the policy. This typically makes term insurance less expensive than permanent life insurance. Term life insurance is usually available in several different configurations, which in some cases can be combined.
There are several types of term life insurance.
Level term
A level term policy pays the same benefit amount if you die at any point during the term. Typically, level term charges the same premium for the policy’s life and is calculated at the beginning of the term based on your current age and health. Level term policies may require a medical exam.
Decreasing term
Decreasing term life insurance also has a set coverage period, but the benefit drops over the policy’s life. Decreasing term covers a debt (such as a mortgage) that decreases over time. Premiums remain the same for the term of the insurance and take into account the fact that the payout will decrease. Ladder Life, for example, offers adjustable coverage, up or down, as needs change, utilizing a digital platform.
Renewable term
A renewable policy continues for an additional term (or terms) up to a specified age, usually 80. With each renewal—five, 10, 15, or 20 years—the premium increases based on your age at that time.
Renewable term guarantees that you can renew the policy even if your health would cause rejection if applying for a new policy. It allows for the flexibility of term insurance while providing continuity, just like permanent insurance.
Return of premium (ROP)
Term insurance, by definition, includes coverage for a set period with no savings or investment. One exception is called “return of premium (ROP)” insurance. With this type of insurance, if you live to the end of the term, you get back all or most of the premiums you have paid. While this sounds like a good deal, there is a cost. First, the premiums are significantly higher than with regular term insurance. You must keep the policy in force until the end of the term, and you only get back the premiums you paid; you don’t earn any interest or dividends on those premiums.
Term life insurance pros and cons
There are several advantages and disadvantages of term insurance, driven chiefly by your circumstances and insurance needs.
Pros
- Affordable premiums. Term insurance is the most budget-friendly insurance available, making it a good fit for people who need maximum coverage at minimum cost.
- Coverage for a specified period. If your insurance needs have a time horizon—such as until you pay off your mortgage or your children are on their own—term insurance is ideal.
- Straightforward and easy to understand. Term insurance is simple. It insures the policyholder for a specific period and pays only if the policyholder dies during that period. There are no cash value, loan, or complicated contract provisions.
Cons
- No cash value. Term insurance is just that: insurance. Your premiums do not go into savings or investments; at the end of the term there is no balance.
- Premiums can increase at renewal. Permanent insurance premiums stay the same for life, while term insurance premiums can increase at policy renewal.
- Not as flexible as permanent insurance. The simplicity of term insurance can also be a problem for those who need the flexibility of permanent insurance, including savings.
What is permanent life insurance?
Permanent life insurance lasts until you die, as long as you pay the premiums. Unlike term insurance, permanent life insurance policies accumulate cash value over time, which can be used as a source of savings to pay future premiums or borrowed against and repaid.
Permanent life insurance policies are more expensive than term insurance policies. They can be more complicated, as they contain savings or investment options and other features not commonly found in term life insurance policies. While there are many variations in permanent life insurance, four types make up the majority of policies.
Whole or ordinary life
This is the most common type of permanent life insurance, and it offers both insurance and savings. Part of your premium pays for insurance, and the balance goes into a savings account that pays dividends and grows over the years. You can withdraw from your savings or borrow (and pay back) funds. Everyday Life, which offers term policies with up to $2 million coverage, also provides whole life insurance for people up to age 85, and says 90% of applicants never have to take a medical exam.
Universal or adjustable life
This type of policy is more flexible than whole life. For example, you may increase the death benefit if you take and pass a medical exam. The savings part of this type of policy usually earns an interest rate equivalent to that of a money market account. You can lower your premium payments if you have enough savings to cover the cost. However, if you use up your savings, your policy may lapse.
Variable life
A variable life policy combines insurance with a savings account that you can invest in stocks, bonds, and money market mutual funds. This type of savings is riskier than a guaranteed interest rate, but it can grow more quickly. If your investments do not do well, your death benefit and cash value may decrease. Some variable life policies guarantee that your death benefit will not fall below a certain level.
Variable-universal life
This hybrid policy combines variable and universal life features. The investment side carries risks and rewards similar to variable life, and the life insurance side lets you adjust your death benefit and premiums like universal life.
Permanent life insurance pros and cons
The pros and cons of permanent life insurance reflect the primary differences between permanent and term policies.
Pros
- Lifetime coverage. This type of insurance covers your lifetime, providing you keep up with premium payments.
- Cash value. Permanent life insurance can accumulate cash value over time.
- Flexibility. The cash value can be used as a source of savings, to pay for future premiums, or as collateral to back up a repayable loan.
Cons
- Expensive. Permanent life insurance policies tend to be more expensive than term policies.
- Complicated. This type of policy can be more complex and challenging to understand than straightforward term insurance.
- Cancellation fees may apply. Your contract may contain cancellation fees or loss of interest. Read the agreement carefully before you sign up.
When is term life insurance the right choice?
Term insurance is best if you need coverage for a specific period, including covering mortgage payments for your beneficiaries, providing college tuition or other financial support, or until your retirement nest egg can take on your financial burdens. Another excellent use for term insurance is for final expenses. Although burial insurance exists, some companies such as Ethos Life, recommend one of their low-coverage term or whole life policies for this type of coverage.
As term insurance tends to be less expensive than permanent life insurance, it is the best option for those with limited resources but significant financial responsibilities. While it doesn’t offer cash value or loan options, it provides the one thing most people need, especially early in their careers and lives: insurance against catastrophic loss of income.
When is permanent life insurance the right choice?
Permanent life insurance makes the most sense if you know you want coverage for your entire lifetime, not just a set period. It can also be a good choice if you want to build cash value and create an inheritance for your loved ones or a favorite charity while paying a set premium.
It’s essential to weigh these factors against the higher cost of permanent life insurance and the difficulty of canceling a policy if circumstances change. For those who want a set amount of coverage over their entire lifetime and want to know how much it will cost them in advance, permanent life insurance is the way to go.
Alternatives to term and permanent life insurance
Although life insurance is the first thing most people consider when contemplating financial protection for loved ones, it’s not the only way to provide that protection.
Will
Whether you have life insurance or other assets to pass on, you should have a will. A will is a legal document that explains how your assets will be distributed after you pass away. You can name beneficiaries and assign them specific assets or percentages of your estate.
Trust
A trust is a legal entity that distributes your accumulated wealth to your heirs, much like a will, after you die. There are many different types of trusts, including revocable, irrevocable, living, and testamentary. The primary advantages of a trust over a will are potential tax benefits and better control over how the trust distributes your assets.
Family bank
One creative way to distribute your assets would be to form a family bank as a legal entity that enables family members to borrow money at a low (or no) interest rate. They would have to pay the money back, making their inheritance self-perpetuating.
Inheritable Roth IRA
Instead of purchasing insurance, you could put your money into an inheritable Roth individual retirement account (IRA) with designated beneficiaries. The funds continue to grow tax free and may be withdrawn tax free. You could convert a traditional IRA to a Roth to avoid saddling your heirs with taxes upon withdrawal. You could do the same with a traditional 401(k) account. In both those cases, you’d need to pay taxes on the funds you convert.
Annuity
Another option, similar to an inheritable IRA, is an annuity. The advantage is that the annuity could be a lump sum or an income stream for the beneficiary’s life. The younger the beneficiary, the more valuable an annuity could be. Of course, though, its cash value lessens as inflation rises.
Self insurance
As simple as it sounds, self insurance means your personal wealth and assets are sufficient to provide for your loved ones after you die. Funds for self insurance could come from savings, investments, even an inheritance you received. Self insurance may also be appropriate if you are debt free and have no dependents.
Real estate
This tactic could include rental properties, a vacation home, or other types of property. You would want to set up a family limited partnership or trust to make transferring the property easier after you die.
TIME Stamp: Term insurance provides maximum protection at minimum cost
When it comes to bang for your buck, it’s no contest. Term life insurance provides the most coverage for the least amount of money. If you want to guarantee your loved ones will be taken care of if you die before you have accumulated enough wealth to do that on your own, term insurance is an inexpensive, easy-to-understand way of achieving your goal.
This does not mean permanent life insurance, in all its permutations, is a wrong choice. If you want to provide protection and build an inheritance by paying a fixed monthly sum for life, permanent life insurance is certainly one way to get there. And, as with term insurance, the proceeds are distributed tax free.
Frequently asked questions (FAQs)
How much life insurance do I need?
You need enough life insurance to equal 10 to 12 times your annual income, according to most experts. Your final figure should take into account other sources of income and assets, such as real estate or valuables, that may alter that figure. The best way to determine how much life insurance you need is to consult with a trusted financial professional. Keep in mind that the coverage you need may change over time, so reassessment on a regular basis is important.
What happens at the end of term life insurance?
Coverage expires at the end of a term life insurance policy. To provide continuing protection for your loved ones, you must renew or take out another policy. Some term policies offer renewal, and some even offer conversion to permanent life insurance if you want to do that. Read your policy carefully before signing up, so that you know your options.
Can you have both term and permanent life insurance at the same time?
Yes. There is no law against simultaneously having a term policy and a permanent life policy. This combination may be desirable in some cases, as it can provide additional short-term coverage at a low cost when you need it most, plus a long-term policy for later in life. As with all life insurance, consult a trusted financial advisor to ensure that this strategy makes sense.
Source: https://time.com/personal-finance/article/term-vs-permanent-life-insurance/